Is the yield curve a modern-day Chicken Little? has been saved
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Is the yield spread reversal cause for panic...or should cooler heads to prevail? We examine how to measure causation.
The yield spread has turned negative, which means that long-term interest rates are below short-term interest rates. And the business media is full of people talking about how a recession must be just around the corner, because the difference between the yield on the 10-year Treasury note and the return on a short-term security (several are popular) has gone negative.
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The spread reversal is certainly troubling, and markets have reacted. But it is no reason for panic. Now is the time for clear headed leaders to develop contingency plans but not to overreact to the 24-hour news cycle.
So, how much attention should we pay to those commentators? The answer is more complicated that you might think. Yield spreads have indeed “predicted” every recession since 1969. The story for recessions before that is not so simple. But the accuracy depends on which yield spread you choose to follow. We’ll look at the difference between the 10-year Treasury note and the Federal funds rate, which is the measure that the Conference Board includes in its Index of Leading Indicators.1
This spread has indeed reversed prior to every recession starting in 1969. It also reversed from May 1966 to February 1967, then went positive again while the economy continued growing. And it reversed in January 1998 for one month and then in June to December 1998, before going positive again—with continued economic growth. That’s a record of predicting seven recessions and giving two false alarms.
An additional problem is the lag between the yield spread turning negative and the business-cycle peak (i.e., the start of the downturn) is extremely variable. It’s taken anywhere from nine months (in 1973 and 2001) and 21 months (in 1969) from the first month in which the yield spread turned negative to the peak. So far, the yield spread (as measured by the 10-year to Fed funds spread) has been negative for two months: suggesting that the recession could start as early as February 2020 or as late as February 2021 and be consistent with historical experience.
Most important, however, is the fact that economists don’t know why the yield spread has turned negative before recessions. Recent Fed research showing the empirical regularity stresses that, without a good theory to explain the data, we need to be a bit skeptical about its meaning. 2
The empirical regularity does not by any means imply that yield spread reversals cause recessions. That means that this time really could be different—if there is something unusual about financial markets, or about the next recession, that is different than the previous seven downturns.